Money Market Fund Reform

Federal RegisterJul 8, 2009

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 274

[Release No. IC-28807; File No. S7-11-09]

RIN 3235-AK33

Money Market Fund Reform

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission” or “SEC”) is proposing amendments to certain rules that govern money market funds under the Investment Company Act. The amendments would: Tighten the risk-limiting conditions of rule 2a-7 by, among other things, requiring funds to maintain a portion of their portfolios in instruments that can be readily converted to cash, reducing the weighted average maturity of portfolio holdings, and limiting funds to investing in the highest quality portfolio securities; require money market funds to report their portfolio holdings monthly to the Commission; and permit a money market fund that has “broken the buck” (

i.e.,

re-priced its securities below $1.00 per share) to suspend redemptions to allow for the orderly liquidation of fund assets. In addition, the Commission is seeking comment on other potential changes in our regulation of money market funds, including whether money market funds should, like other types of mutual funds, effect shareholder transactions at the market-based net asset value,

i.e.,

whether they should have “floating” rather than stabilized net asset values. The proposed amendments are designed to make money market funds more resilient to certain short-term market risks, and to provide greater protections for investors in a money market fund that is unable to maintain a stable net asset value per share.

DATES:

Comments should be received on or before September 8, 2009.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form (

http://www.sec.gov/rules/proposed.shtml

); or

• Send an e-mail to

rule-comments@sec.gov.

Please include File Number S7-11-09 on the subject line; or

• Use the Federal eRulemaking Portal (

http://www.regulations.gov

). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-11-09. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (

http://www.sec.gov/rules/proposed.shtml

). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT:

Office of Regulatory Policy, at (202) 551-6792, Division of Investment Management, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION:

The Commission is proposing for public comment amendments to rules 2a-7 [17 CFR 270.2a-7], 17a-9 [17 CFR 270.17a-9], and 30b1-5 [17 CFR 270.30b1-5], new rules 22e-3 [17 CFR 270.22e-3] and 30b1-6 [17 CFR 270.30b1-6], and new Form N-MFP under the Investment Company Act of 1940 (“Investment Company Act” or “Act”).

15 U.S.C. 80a. Unless otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act, including rule 2a-7, will be to Title 17, Part 270 of the Code of Federal Regulations [17 CFR part 270].

Table of Contents

I. Background

A. Money Market Funds

B. Market Significance

C. Regulation of Money Market Funds

D. Recent Developments

II. Discussion

A. Portfolio Quality

1. Second Tier Securities

2. Eligible Securities

3. Credit Reassessments

4. Asset Backed Securities

B. Portfolio Maturity

1. Weighted Average Maturity

2. Weighted Average Life

3. Maturity Limit for Government Securities

4. Maturity Limit for Other Portfolio Securities

C. Portfolio Liquidity

1. Limitation on Acquisition of Illiquid Securities

2. Cash and Securities That Can Be Readily Converted to Cash

3. Stress Testing

D. Diversification

E. Repurchase Agreements

F. Disclosure of Portfolio Information

1. Public Web site Posting

2. Reporting to The Commission

3. Amendment to Rule 30b1-5

G. Processing of Transactions

H. Exemption for Affiliate Purchases

1. Expanded Exemptive Relief

2. New Reporting Requirement

I. Fund Liquidation

1. Proposed Rule 22e-3

2. Request for Comment on Other Regulatory Changes

III. Request for Comment

A. Floating Net Asset Value

B. In-Kind Redemptions

IV. Paperwork Reduction Act Analysis

V. Cost Benefit Analysis

VI. Competition, Efficiency And Capital Formation

VII. Regulatory Flexibility Act Certification

VIII. Statutory Authority

Text of Proposed Rules and Form

I. Background

A. Money Market Funds

Money market funds are open-end management investment companies that are registered under the Investment Company Act and regulated under rule 2a-7 under the Act. They invest in high-quality, short-term debt instruments such as commercial paper, Treasury bills and repurchase agreements.

Money market funds pay dividends that reflect prevailing short-term interest rates and, unlike other investment companies, seek to maintain a stable net asset value per share, typically $1.00 per share.

Money market funds are also sometimes called “money market mutual funds” or “money funds.”

See generally

Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies (Money Market Funds), Investment Company Act Release No. 13380 (July 11, 1983) [48 FR 32555 (July 18, 1983)] (“1983 Adopting Release”). Most money market funds seek to maintain a stable net asset value per share of $1.00, but a few seek to maintain a stable net asset value per share of a different amount,

e.g.,

$10.00. For convenience, throughout this release, the discussion will simply refer to the stable net asset value of $1.00 per share.

This combination of stability of principal and payment of short-term yields has made money market funds one of the most popular investment vehicles for many different types of investors. Commonly offered features, such as check-writing privileges, exchange privileges, and near-immediate liquidity, have contributed to the popularity of money market funds. More than 750 money market funds are registered with the Commission, and collectively they hold approximately

$3.8 trillion of assets.

Money market funds account for approximately 39 percent of all investment company assets.

See

Investment Company Institute,

Trends in Mutual Fund Investing,

Apr. 2009,

available at http://www.ici.org/highlights/trends_04_09

(“ICI Trends”).

See id.

Individual (or “retail”) investors use money market funds for a variety of reasons. For example, they may invest in money market funds to hold cash temporarily or to take a temporary “defensive position” in anticipation of declining equity markets. Money market funds also play an important role in cash management accounts for banks, broker-dealers, variable insurance products, and retirement accounts. As of December 2008, about one-fifth of U.S. households' cash balances were held in money market funds.

See

Investment Company Institute, Report of the Money Market Working Group, at 21 (Mar. 17, 2009),

available at http://www.ici.org/pdf/ppr_09_mmwg.pdf

(“ICI Report”).

Different types of money market funds have been introduced to meet the differing needs of retail money market fund investors. Historically, most retail investors have invested in “prime money market funds,” which hold a variety of taxable short-term obligations issued by corporations and banks, as well as repurchase agreements and asset backed commercial paper secured by pools of assets.

Prime money market funds typically have paid higher yields than other types of money market funds available to retail investors.

“Government money market funds” principally hold obligations of the U.S. Government, including obligations of the U.S. Treasury and federal agencies and instrumentalities, as well as repurchase agreements collateralized by Government securities. Some government money market funds limit themselves to holding only Treasury obligations. Compared to prime funds, government funds generally offer greater safety of principal but historically have paid lower yields. “Tax exempt money market funds” primarily hold obligations of state and local governments and their instrumentalities, and pay interest that is generally exempt from federal income taxes.

See

Investment Company Institute, 2009 Investment Company Fact Book, at 147, Table 38 (May 2009),

available at http://www.ici.org/pdf/2009_factbook.pdf

(“2009 Fact Book”).

See, e.g.,

iMoneyNet Money Fund Report

(Mar. 20, 2009),

available at http://www.imoneynet.com/files/Publication_News/mfr.pdf.

Institutional investors account for a growing portion of investments in money market funds. These investors include corporations, bank trust departments, securities lending operations of brokerage firms, state and local governments, hedge funds and other private funds. Many corporate treasurers of large businesses have essentially “outsourced” cash management operations to money market funds, which may be able to manage cash more efficiently due both to the scale of their operations and their expertise. As of January 2008, approximately 80 percent of U.S. companies used money market funds to manage at least a portion of their cash balances.

At year-end 2008, U.S. non-financial businesses held approximately 32 percent of their cash balances in money market funds.

According to the Investment Company Institute, about 66 percent of money market fund assets are held in money market funds or share classes intended to be sold to institutional investors (“institutional money market funds”).

See

ICI Report,

supra

note 6, at 28-29, Figure 3.7.

See id.

at 28-29, Figure 3.6.

See

Investment Company Institute,

Money Market Mutual Fund Assets,

June 11, 2009,

available at http://www.ici.org/highlights/mm_06_11_09.

Institutional money market funds hold securities similar to those held by prime funds and government funds. They typically have large minimum investment amounts (

e.g.,

$1 million), and offer lower expenses and higher yields due to the large account balances, large transaction values, and smaller number of accounts associated with these funds. As we will discuss in more detail below, institutional money market funds also tend to have greater investment inflows and outflows than retail money market funds.

B. Market Significance

Due in large part to the growth of institutional funds, money market funds have grown substantially over the last decade, from approximately $1.4 trillion in assets under management at the end of 1998 to approximately $3.8 trillion in assets under management at the end of 2008.

During this same period, retail taxable money market fund assets grew from approximately $835 billion to $1.36 trillion, or 63 percent, while institutional taxable money market fund assets grew from approximately $516 billion to $2.48 trillion, or 380 percent.

See

Investment Company Institute, 1999 Mutual Fund Fact Book, at 4 (May 1999), available at

http://www.ici.org/pdf/1999_factbook.pdf;

Investment Company Institute,

Trends in Mutual Fund Investing,

May 28, 2009, available at

http://www.ici.org/highlights/trends_04_2009.

See

Investment Company Institute, 2008 Investment Company Fact Book, at 144, Table 35 (May 2008) (“2008 Fact Book”); 2009 Fact Book,

supra

note 7, at 147, Table 38.

One implication of the growth of money market funds is the increased role they play in the capital markets. They are by far the largest holders of commercial paper, owning almost 40 percent of the outstanding paper.

The growth of the commercial paper market has generally followed the growth of money market funds over the last three decades.

Today, money market funds provide a substantial portion of short-term credit extended to U.S. businesses.

Federal Reserve Board, Statistical Release Z.1: Flow of Funds Accounts of the United States: Flows and Outstandings Fourth Quarter 2008, at 86, Table L.208 (Mar. 12, 2009), available at

http://www.federalreserve.gov/releases/z1/Current/z1.pdf

(“Fed. Flow of Funds Report”).

See

Instruments of the Money Market, at 121, Table 2 (Timothy Q. Cook & Robert K. Laroche eds., 1993), available at

http://www.richmondfed.org/publications/research/special_reports/instruments_of_the_money_market/pdf/full_publication.pdf;

Fed. Flow of Funds Report,

supra

note 14, at Tables L.206 and L.208. One commenter has called the growth of these two markets “inextricably linked.”

See

Leland Crabbe & Mitchell A. Post,

The Effect of SEC Amendments to Rule 2a-7 on the Commercial Paper Market,

at 4 (Federal Reserve Board, Finance and Economics Discussion Series #199, May 1992) (“Crabbe & Post”).

Money market funds also play a large role in other parts of the short-term market. They hold approximately 23 percent of all repurchase agreements, 65 percent of state and local government short-term debt, 24 percent of short-term Treasury securities, and 44 percent of short-term agency securities.

They serve as a substantial source of financing in the broader capital markets, holding approximately 22 percent of all state and local government debt, approximately nine percent of U.S. Treasury securities and 15 percent of agency securities.

These securities include securities issued or guaranteed by the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal Home Loan Banks.

See

ICI Report,

supra

note 6, at 19, Figure 2.3.

See generally

U.S. Treasury Department, FAQs on Fixed Income Agency Securities, available at

http://www.treas.gov/education/faq/markets/fixedfederal.shtml.

See

Fed. Flow of Funds Report,

supra

note 14 (percentages derived from flow of funds data). Foreign banks also have relied substantially on U.S. money market funds for dollar-denominated funding.

See

Naohiko Baba, Robert N. McCauley, & Srichander Ramaswamy,

U.S. Dollar Money Market Funds and non-U.S. Banks,

BIS Quarterly Review, Mar. 2009,

available at http://www.bis.org/publ/qtrpdf/r_qt0903g.htm

(“U.S. Dollar Money Market Funds”).

As a consequence, the health of money market funds is important not only to their investors, but also to a

large number of businesses and state and local governments that finance current operations through the issuance of short-term debt. A “break in the link [between borrowers and money market funds] can lead to reduced business activity and pose risks to economic growth.”

The regulation of money market funds, therefore, is important not only to fund investors, but to a wide variety of operating companies as well as state and local governments that rely on these funds to purchase their short-term securities.

See

Mike Hammill & Andrew Flowers,

MMMF, and AMLF, and MMIFF,

Macroblog (Federal Reserve Bank of Atlanta), Oct. 30, 2008, available at

http://www.macroblog.typepad.com/macroblog/2008/10/index.html.

C. Regulation of Money Market Funds

The Commission regulates money market funds under the Investment Company Act and pursuant to rule 2a-7 under the Act. We adopted rule 2a-7 as an exemptive rule in 1983 and amended it in 1986 to facilitate the development of tax-exempt money market funds.

We also amended it substantially in 1991 (taxable funds) and 1996 (tax-exempt funds) to provide for a more robust set of regulatory conditions and to expand the rule to apply it to any investment company holding itself out as a money market fund.

See

1983 Adopting Release,

supra

note 3; Acquisition and Valuation of Certain Portfolio Instruments by Registered Investment Companies, Investment Company Act Release No. 14983 (Mar. 12, 1986) [51 FR 9773 (Mar. 21, 1986)] (“1986 Adopting Release”).

See

Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 18005 (Feb. 20, 1991) [56 FR 8113 (Feb. 27, 1991)] (“1991 Adopting Release”); Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 21837 (Mar. 21, 1996) [61 FR 13956 (Mar. 28, 1996)] (“1996 Adopting Release”).

The Investment Company Act and applicable rules generally require that mutual funds price their securities at the current net asset value per share by valuing portfolio instruments at market value or, if market quotations are not readily available, at fair value determined in good faith by the board of directors.

As a consequence, the price at which funds will sell and redeem shares ordinarily fluctuates daily with changes in the value of the fund's portfolio securities. These valuation and pricing requirements are designed to prevent investors' interests from being diluted or otherwise adversely affected if fund shares are not priced fairly.

See

section 2(a)(41) of the Act (defining “value” of fund assets); rule 2a-4 (defining “current net asset value” for use in computing the current price of a redeemable security); and rule 22c-1 (generally requiring open-end funds to sell and redeem their shares at a price based on the funds' current net asset value as next computed after receipt of a redemption, purchase, or sale order).

See

Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 17589 at n.7 and accompanying text (July 17, 1990) [55 FR 30239 (July 25, 1990)] (“1990 Proposing Release”).

Rule 2a-7, however, permits money market funds to use the amortized cost method of valuation and penny-rounding method of pricing instead, which facilitate money market funds' ability to maintain a stable net asset value.

Under the amortized cost method, portfolio securities generally are valued at cost plus any amortization of premium or accumulation of discount (“amortized cost”).

The basic premise underlying money market funds' use of the amortized cost method of valuation is that high-quality, short-term debt securities held until maturity will eventually return to the amortized cost value, regardless of any current disparity between the amortized cost value and market value, and would not ordinarily be expected to fluctuate significantly in value.

Therefore, the rule permits money market funds to value portfolio securities at their amortized cost so long as the deviation between the amortized cost and current market value remains minimal and results in the computation of a share price that represents fairly the current net asset value per share of the fund.

The penny-rounding method of pricing means the method of computing a fund's price per share for purposes of distribution, redemption and repurchase whereby the current net asset value per share is rounded to the nearest one percent.

See

rule 2a-7(a)(18).

See

rule 2a-7(a)(2) (defining the amortized cost method as calculating an investment company's net asset value whereby portfolio securities are valued at the fund's acquisition cost as adjusted for amortization of premium or accretion of discount rather than at their value based on current market factors).

See

1983 Adopting Release,

supra

note 3, at nn. 3-7 and accompanying text; Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies, Investment Company Act Release No. 12206, at nn. 3-4 and accompanying text (Feb. 1, 1982) [47 FR 5428 (Feb. 5, 1982)] (“1982 Proposing Release”).

See

rule 2a-7(c)(1), (c)(7)(ii)(C).

To reduce the likelihood of a material deviation occurring between the amortized cost value of a portfolio and its market-based value, the rule contains several conditions (which we refer to as “risk-limiting conditions”) that limit the fund's exposure to certain risks, such as credit, currency, and interest rate risks.

In addition, the rule includes certain procedural requirements overseen by the fund's board of directors. One of the most important is the requirement that the fund periodically “shadow price” the amortized cost net asset value of the fund's portfolio against the mark-to-market net asset value of the portfolio.

If there is a difference of more than

1/2

of 1 percent (or $0.005 per share), the fund's board of directors must consider promptly what action, if any, should be taken, including whether the fund should discontinue the use of the amortized cost method of valuation and re-price the securities of the fund below (or above) $1.00 per share, an event colloquially known as “breaking the buck.”

For example, the rule requires, among other things, that a money market fund's portfolio securities meet certain credit quality requirements, such as being rated in the top one or two rating categories by nationally recognized statistical rating organizations (“NRSROs”), and by limiting the portion of the fund's portfolio that may be invested in securities rated in the second highest rating category.

See

rule 2a-7(c)(3). The rule also places limits on the remaining maturity of securities in the fund's portfolio. A fund generally may not acquire, for example, any securities with a remaining maturity greater than 397 days, and the dollar-weighted average maturity of the securities owned by the fund may not exceed 90 days.

See

rule 2a-7(c)(2).

See

rule 2a-7(c)(7);

See also

Press Release, Federal Reserve Board Announces Creation of the Commercial Paper Funding Facility (CPFF) to Help Provide Liquidity to Term Funding Markets (Oct. 7, 2008),

available at http://www.federalreserve.gov/newsevents/press/monetary/20081007c.htm

(“The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.”).

See

Matthew Cowley,

Burnt Money Market Funds Stymie Short-Term Debt,

Dow Jones International News, Oct. 1, 2008; Anusha Shrivastava,

Commercial-Paper Market Seizes Up,

The Wall Street Journal, Sept. 19, 2008, at C2.

See

Federal Reserve Board data,

available at http://www.frbatlanta.org/econ_rd/macroblog/102808b.jpg

(charting three-month commercial paper spreads over three-month Treasury bill);

See also

rule 2a-7(a)(10) (defining “eligible security”), (a)(22) (defining “second tier security” as any eligible security that is not a first tier security), and (a)(12) (defining “first tier security” as, among other things, any eligible security that, if rated, has received the highest short-term term debt rating from the requisite NRSROs or, if unrated, has been determined by the fund's board of directors to be of comparable quality).

See also

1990 Proposing Release,

supra

note 22, at Section II.1.b.

Rule 2a-7(c)(3)(ii)(B).

See also

rule 2a-7(a)(7) (defining “conduit security”).

We are also proposing a change to the provisions of rule 2a-7 that limit money market funds to investing in high quality securities. We propose to generally limit money market fund investments to securities rated in the highest NRSRO ratings category. In addition, we are seeking comment on whether to modify provisions of the rule that incorporate minimum ratings by NRSROs to reflect changes made to the federal securities laws by the Credit Rating Agency Reform Act of 2006 (“Rating Agency Reform Act”).

Credit Rating Agency Reform Act of 2006, Pub. L. 109-291, 120 Stat. 1327.

1. Second Tier Securities

We propose to amend rule 2a-7 to allow money market funds to invest only in first tier securities. Under the proposed amendments, money market funds could “acquire” only “eligible securities,” which would be re-defined to include securities receiving only the highest (rather than the highest two) short-term debt ratings from the “requisite NRSROs.”

Funds would not have to immediately dispose of a security that was downgraded by the requisite NRSROs but, under existing provisions of rule 2a-7, the fund would have to dispose of the security “as soon as practicable consistent with achieving an orderly disposition of the security” unless the fund's board of directors finds that such disposal would not be in the best interest of the fund.

See

rule 2a-7(a)(1) (defining acquisition (or acquire) as any purchase or subsequent rollover, but not including the failure to exercise a demand feature); proposed rule 2a-7(a)(11)(iii) (defining eligible security); proposed rule 2a-7(c)(3) (portfolio quality). Because eligible securities would no longer be divided into first tier and second tier securities, both of those terms would be deleted from the rule, as would provisions relating specifically to second tier securities.

See

rule 2a-7(a)(12), (a)(22), (c)(3)(ii), (c)(4)(i)(C), (c)(4)(iii)(B), (c)(6)(i)(A), and (c)(6)(i)(C). We would therefore amend the definition of eligible security to require that securities receive “the highest,” as opposed to “one of the two highest” short-term rating categories, as the current definition provides, and delete other references in the rule to the second highest rating category.

See

proposed rule 2a-7(a)(11)(iii). The definition of eligible security also would be expanded to include two types of securities, securities issued by a money market fund and “Government securities,” that were formerly part of the definition of first tier securities.

See

proposed rule 2a-7(a)(11)(i) and (ii);

See also

1991 Adopting Release,

supra

note 20.

See

1991 Adopting Release,

supra

note 20, at n.36 and accompanying text. Most commenters representing the mutual fund industry supported or did not oppose the limitations we proposed.

Id.

at n.35 and accompanying text.

See id.

at text following n.35.

See id.

at n.35-37 and accompanying text; 1990 Proposing Release,

supra

note 22, at n.33 and accompanying text.

Second tier securities were not directly implicated in the recent strains on money market funds. The ICI's Money Market Working Group expressed concern to us, however, that these securities may present an “imprudent” risk to the stable value of money market funds because they present “weaker credit profiles, smaller overall market share, and smaller issuer program sizes * * *”

Our examination of the data discussed below suggests support for their recommendation that money market funds no longer be permitted to invest in these securities.

ICI Report,

supra

note 6, at 101.

Id.

at 100.

Compared to the market for first tier securities, the market for second tier securities is relatively small. As of June 24, 2009, there was $1082.5 billion in rule 2a-7-eligible commercial paper outstanding, consisting of $1035.8 billion (95.7 percent) of first tier and $46.7 billion (4.3 percent) of second tier.

The size of the second tier market has remained consistently small over time.

See

Federal Reserve Board Commercial Paper Outstanding Chart,

available at http://www.federalreserve.gov/releases/cp/outstandings.htm

(showing weekly levels of rule 2a-7-eligible commercial paper outstanding).

See

Federal Reserve Board Commercial Paper Data Download Program,

available at http://www.federalreserve.gov/DataDownload/Choose.aspx?rel=CP

(select year-end outstandings from the preformatted data package menu and follow the instructions for download). Over the last eight years, the market for second tier securities on average has represented only 4.6 percent of the rule 2a-7-eligible commercial paper market.

In addition, second tier securities present potentially substantially more risk than first tier securities. As the following chart shows, during the market disruptions of last fall, second tier securities experienced significantly wider credit spreads than first tier securities.

See

Federal Reserve Board Commercial Paper Rates Chart,

available at http://www.federalreserve.gov/releases/cp/default.htm.

See also

Frank J. Fabozzi, The Handbook of Fixed Income Securities, at 4 (7th ed. 2005) (“Default risk or credit risk refers to the risk that the issuer of a bond may be unable to make timely payment of principal or interest payments * * *. The spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality is referred to as a

credit spread

quality spread.

”).

EP08JY09.000

Second tier securities as an asset class also are of weaker credit quality in terms of interest coverage ratios, debt coverage ratios, and debt to equity ratios.

These data strongly suggest that second tier securities generally present additional risks to a money market fund. This is a conclusion that may have been reached by money market fund managers, most of which (as described below) do not invest in second tier securities. In light of the risks that second tier securities generally present to money market funds, and the consequences to funds and fund investors of breaking a dollar, we are proposing to limit funds to investing in first tier securities. We believe such a limitation would make it less likely that a money market fund would hold a problematic security, or a security that would lose significant value as a result of market disruptions.

See

Standard & Poor's, CreditStats: 2007 Adjusted Key U.S. Industrial and Utility Financial Ratios, at 6, Table 3 (Sept. 10, 2008),

available at http://www2.standardandpoors.com/spf/pdf/fixedincome/CreditStats_2007_Adjusted_Key_Financial_Ratios.pdf

(showing A-2 rated commercial paper had EBIT interest coverage of 7.2x, free operating cash flow to debt of 16.7%, and debt to debt plus equity of 45.1%, compared to A-1 averages of 11.5x, 31.3%, and 37.1%, respectively, represented as three-year (2005-2007) averages).

It does not appear that amending rule 2a-7 to eliminate money market funds' ability to acquire second tier securities would be materially disruptive to funds. Prior to our amendments to rule 2a-7 in 1991, non-government money market funds held more than eight percent of their assets in second tier securities.

100

After we restricted the amount of second tier securities money market funds could buy, the funds soon reduced their holdings to almost zero.

101

Our staff's review of money market fund portfolios in September 2008 found that second tier securities represented only 0.4 percent of the $3.6 trillion held by the funds (approximately $14.6 billion).

100

See

Crabbe & Post,

supra

note 15, at 11, Table 2.

101

See id.

at 11-12.

We request comment on our proposal to eliminate the ability of money market funds to invest in second tier securities. What would be the impact on funds? Would the benefit of reducing credit risk by eliminating the ability of money market funds to invest in second tier securities outweigh any potential diversification benefits that second tier securities may otherwise provide to money market funds? What, if any, diversification benefits do money market funds currently receive from investing in second tier securities? Would this change have a significant effect on yields?

Would there be a proportionately greater impact of eliminating second tier securities on smaller or less established money market funds or on particular types of funds (

e.g.,

single-state tax exempt funds)? If the proposal to eliminate funds' ability to hold second tier securities is adopted, what transition period should we provide money market funds to dispose of their existing second tier holdings in an orderly manner? Should we allow funds that hold second tier securities after the amended rule becomes effective to continue to hold such securities until maturity?

Are there alternatives to eliminating entirely the ability of a money market fund to invest in second tier securities? For example, should money market funds instead be limited to investing in second tier securities (i) with a maximum maturity of, for example, 45 days, or (ii) as a smaller portion of fund assets, such as two percent of the total assets, or (iii) a combination of both? A security with a shorter maturity presents less credit risk to a fund (because the exposure is shorter) and less liquidity risk (because cash will be available sooner). Would such an approach address, or at least partly address, the concerns raised by the ICI Report and in this Release?

102

Could additional credit risk analysis or other procedures be imposed with respect to second tier securities to address these concerns?

102

See

ICI Report,

supra

note 6, at 100-101.

2. Eligible Securities

a. Use of NRSROs

As discussed above, rule 2a-7 currently requires a money market fund to limit its portfolio investments to eligible securities,

i.e.,

short-term securities that at the time of acquisition have received ratings from the “requisite NRSROs” in one of the two highest short-term debt rating categories and securities that are comparable to rated securities.

103

See supra

note 84 and accompanying text. A “rated security” generally means a security that (i) has received a short-term rating from an NRSRO, or whose issuer has received a short-term rating from an NRSRO with respect to a class of debt obligations that is comparable in priority and security with the security; or (ii) is subject to a guarantee that has received a short-term rating from an NRSRO, or a guarantee whose issuer has received a short-term rating from an NRSRO with respect to a class of debt obligations that is comparable in priority and security with the guarantee. Rule 2a-7(a)(19).

A determination that a security is an eligible security as a result of its NRSRO ratings is a necessary but not sufficient finding in order for a fund to acquire the security.

104

References to NRSRO ratings in rule 2a-7 and other regulations were designed to provide a clear reference point to regulators and market participants. The reliability of credit ratings, however, has been questioned, in particular in light of developments during the recent financial crisis. As a result, there have been calls to produce higher quality ratings. Last year, we proposed to eliminate the use of NRSRO ratings in rules under the Investment Company Act, including rule 2a-7, and instead to rely solely on the fund manager's credit risk determination.

105

In 2003, in a concept release seeking comment on various issues relating to credit rating agencies, we also asked whether credit ratings should be used as a minimum objective standard in rule 2a-7. Most commenters who addressed the specific question in 2003 supported retaining the ratings requirement in rule 2a-7.

106

One commenter asserted that “[t]he combination of this objective test with the ‘subjective test’ (credit analysis performed by the adviser to the money market fund) provides an important complementary rating structure under Rule 2a-7.”

107

Similarly, in our proposal last year, a substantial majority of commenters disagreed with the proposed elimination of the ratings requirement.

108

The ICI Report summed up the views of many of these commenters, asserting that elimination of the NRSRO ratings' “floor * * * would remove an important investor protection from Rule 2a-7, introduce new uncertainties and risks, and abandon a regulatory framework that has proven to be highly successful.”

109

A few commenters supported removing the ratings requirement in 2003 and as proposed in 2008, however. One of these commenters noted that “one of the core causes of the sub-prime crisis was dependence on inaccurate and unsupportable credit ratings.”

110

104

The rule also requires fund boards (which typically rely on the fund's adviser) to determine that the security presents minimal credit risks, and specifically requires that determination “be based on factors pertaining to credit quality in addition to any ratings assigned to such securities by an NRSRO.” Rule 2a-7(c)(3)(i).

105

See, e.g.,

References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Company Act Release No. 28327 (July 1, 2008) [73 FR 40124 (July 11, 2008)] (“NRSRO References Proposal”).

106

See, e.g.,

Comment Letter of Fidelity Investments (July 25, 2003) (File No. S7-12-03). Comment letters on File No. S7-12-03 are available at

http://www.sec.gov/rules/concept/s71203.shtm

107

Comment Letter of Denise Voigt Crawford, Securities Commissioner, Texas State Securities Board (July 28, 2003) (File No. S7-12-03).

108

See, e.g.,

Comment Letter of T. Rowe Price Family of Funds (Sept. 5, 2008) (File No. S7-19-08). Comment letters on File No. S7-19-08 are available at

http://www.sec.gov/comments/s7-19-08/s71908.shtml.

109

See

ICI Report,

supra

note 6, at 81.

110

See

Comment Letter of Professor Frank Partnoy (received Sept. 5, 2008) (File No. S7-19-08).

In light of recent market developments, we request that commenters again address whether or not the approach we proposed last year would provide safeguards with respect to credit risk that are comparable to the continued inclusion of NRSRO references in the rule. What other alternatives could we adopt to encourage more independent credit risk analysis and meet the regulatory objectives of rule 2a-7's requirement of NRSRO ratings? Are there additional factors that we should consider with respect to last year's proposal? Should we consider establishing a roadmap for phasing in the eventual removal of NRSRO references from the rule? We are also considering an approach under which a money market fund's board would designate three (or more) NRSROs that the fund would look to for all purposes under rule 2a-7 in determining whether a security is an eligible security.

111

In addition, the board would be required to determine at least annually that the NRSROs it has designated issue credit ratings that are sufficiently reliable for that use.

112

We request comment on an approach in which the fund board designates NRSROs. Would the inclusion of a number of “designated NRSROs” improve rule 2a-7's use of NRSRO ratings as a threshold investment criterion and be consistent with the goals of Congress in passing the Rating Agency Reform Act?

113

What are the advantages and disadvantages of such an approach? Should funds be required to designate a minimum number of NRSROs to use in determining thresholds for Eligible Securities or in monitoring ratings? If so, would at least three be the appropriate number, as some have suggested?

114

Would more be appropriate to address these purposes (

e.g.,

four, five or six)? Should we permit fund boards to designate different NRSROs with respect to different types of issuers of securities in which the fund invests? Should the funds be required to disclose these designated NRSROs in their statements of additional information?

115

111

Commenters on our NRSRO References Proposal and the ICI Report recommended similar approaches.

See

Comment Letter of Federated Investors, Inc. (Sept. 5, 2008) (File No. S7-19-08) (suggesting that rule 2a-7 require the board or its delegate to select by security type at least three NRSROs on which the fund would rely under the rule); Comment Letter of OppenheimerFunds, Inc. (Sept. 4, 2008) (File No. S7-19-08) (suggesting the rule allow fund boards to designate (presumably after considering any recommendations of the investment manager) the identity and number of NRSROs whose ratings will be used to determine eligible portfolio securities); ICI Report,

supra

note 6, at 82 (recommending the fund designate three or more NRSROs that the fund would use in determining the eligibility of portfolio securities).

See also

Comment Letter of Stephen A. Keen on behalf of Federated Investors, Inc. (Mar. 12, 2007) (File No. S7-04-07) (in response to our 2007 proposal on oversight of NRSROs, asserting that investment advisers should be free to choose which NRSROs they will rely upon and monitor only their ratings).

112

The only time that funds would be required to look to all NRSROs under this approach would be, as under the current rule, in determining whether a long-term security with a remaining maturity of 397 calendar days or less that does not, and whose issuer does not, have a short-term rating is an eligible security.

See infra

section II.A.2.b.

113

See

Senate Committee on Banking, Housing, and Urban Affairs, Credit Rating Agency Reform Act of 2006, S. Rep. No. 109-326, at 2 (2006) (“Senate Report 109-326”) (purposes of the Act include improving the quality of NRSRO credit ratings by fostering accountability, transparency, and competition in the credit rating industry).

114

See supra

note 111.

115

See

Part B of Form N-1A.

What impact would a requirement that the fund board designate NRSROs have on competition among NRSROs? Would NRSROs compete through ratings to achieve designation by money market funds? Given that the staff believes it is reasonable to assume that the three NRSROs that issued almost 99 percent of all outstanding ratings across all categories that were issued by the 10 registered NRSROs as of June 2008,

116

also issued well over 90 percent of all outstanding ratings of short term debt, and in light of concerns about enhancing competition among NRSROs, should the minimum number of designated NRSROs be greater than three, such as four, five, or six?

117

What are the advantages and disadvantages of requiring boards to monitor the ratings issued by all NRSROs? Should rule 2a-7 specify certain minimum policies and procedures for monitoring NRSROs? Should money market fund boards be permitted to designate credit rating agencies or credit evaluation providers that are not registered as NRSROs with the Commission under the Securities Exchange Act of 1934 and the rules we have adopted under those provisions?

118

Should a board be solely responsible for designating and annually reviewing a designated NRSRO or should we permit delegation of this responsibility? How many NRSROs would money market fund boards be likely to evaluate before making their designations? After a fund board had designated NRSROs, what incentives would the board have to change the designated NRSROs?

116

The staff's belief is based on its report that three NRSROs issued almost 99 percent of all the outstanding ratings across all categories that were

issued by the 10 registered NRSROs as of June 2008.

See

SEC, Annual Report on Nationally Recognized Statistical Rating Organizations at 35 (June 2008) (“2008 NRSRO Report”).

117

According to the ICI Report, requiring money market funds to designate at least three NRSROs whose ratings the fund would use in determining eligible portfolio securities could encourage competition among NRSROs to achieve designation by money market funds.

See

ICI Report,

supra

note 6, at 82.

118

See

15 U.S.C. 78o-7; 17 CFR 240.17g-1 (rules governing the registration of NRSROs).

We request comment on the impact of any of these approaches on funds and their ability to maintain a stable net asset value. Would any particular requirement help funds to better determine whether a security is an eligible security? We also request comment on the potential impact on competition among NRSROs.

b. Long-Term Unrated Securities

Rule 2a-7 permits money market funds to invest in a long-term security with a remaining maturity of 397 calendar days or less (“stub security”) that is an unrated security (

i.e.,

neither the security nor its issuer or guarantor has a short-term rating) unless the security has received a long-term rating from any NRSRO that is not within the NRSRO's three highest categories of long-term ratings.

119

Under rule 2a-7, the measure of quality is the rating given to the issuer's short-term debt. In the absence of a short-term rating, the minimum long-term rating is designed to provide an independent check on a fund's quality determination.

120

In light of the changes we are proposing above to increase the portfolio quality standards of the rule, we propose to permit money market funds to acquire such securities only if they have received long-term ratings in the highest two ratings categories to more narrowly limit the credit risk to which a money market fund may be exposed.

121

As under the current rule, fund boards would continue to be required to determine that such a security is “of comparable quality” to a rated security if it met these proposed conditions.

122

119

Rule 2a-7(a)(10)(ii)(A). Nonetheless, the security may be an eligible security if it has received a long-term rating from the requisite NRSROs in one of the three highest long-term rating categories and (as with any unrated security that is an eligible security) is of comparable quality to a rated security.

Id.

120

See

1991 Adopting Release,

supra

note 20, at text accompanying nn.65-68.

121

Proposed rule 2a-7(a)(11)(iv)(A). Similar to the provision in the current rule, the security might be an eligible security even if it received a long-term rating below the two highest long-term rating categories if the requisite NRSROs rate the security in one of the two highest long-term rating categories.

Id.

122

Proposed rule 2a-7(a)(11)(iv).

We request comment on this proposed change. Given our proposal to increase the quality standards of the rule, is the proposed change appropriate? Should we consider permitting funds to acquire these stub securities only if they have received long-term ratings in the highest rating category? What impact would the proposed amendment have on money market funds' current portfolio holdings? We request commenters expressing views on this change to provide us with data identifying the relationship between the long-term ratings on these stub securities and short-term ratings.

3. Credit Reassessments

Rule 2a-7 currently requires a money market fund's board of directors to promptly reassess whether a portfolio security continues to present minimal credit risks if, subsequent to its acquisition by the fund, (i) the security has ceased to be a first tier security (

e.g.,

the security is downgraded to second tier by one of the requisite NRSROs), or (ii) the fund's adviser becomes aware that an unrated or second tier security has received a rating from any NRSRO below the second highest short-term rating category.

123

In light of the proposed elimination of second tier securities from the definition of eligible security, we propose to amend rule 2a-7 so the only circumstance in which the fund's board of directors would be required to reassess whether a security continues to present minimal credit risks would be if, subsequent to its acquisition by the fund, the fund's money market fund adviser becomes aware that an unrated security has received a rating from any NRSRO below the highest short-term rating category.

124

123

Rule 2a-7(c)(6)(i)(A)(1) and (2).

124

Proposed rule 2a-7(c)(7)(i)(A). As under the current rule, the proposed rule amendment would not require, and we would not expect, investment advisers to subscribe to every rating service publication in order to comply with the requirement that the board reassess when the fund's adviser becomes aware that any NRSRO has rated an unrated security below its highest rating. We would expect an investment adviser to become aware of a subsequent rating if it is reported in the national financial press or in publications to which the adviser subscribes.

See

1991 Adopting Release,

supra

note 20, at n.71.

We request comment on whether these are appropriate circumstances under which to require a reassessment in light of our proposal to eliminate the ability of money market funds to invest in second tier securities.

4. Asset Backed Securities

Rule 2a-7 contains provisions that specifically address asset backed securities (“ABSs”),

125

including the circumstances under which an ABS is an eligible security,

126

the maturity of an ABS,

127

and how a fund must treat such an investment under the diversification provisions.

128

The rule, however, does not specifically address how a fund board (or its delegate) should determine that an investment in an ABS (or other potential portfolio investment) presents minimal credit risks, nor does it specifically address liquidity issues presented by a money market fund's investment in an ABS.

125

An asset backed security is defined very generally to mean a fixed income security that entitles its holders to receive payments that depend primarily on the cash flow from financial assets underlying the asset backed security.

See

rule 2a-7(a)(3).

126

See

rule 2a-7(a)(10)(ii)(B).

127

See

rules 2a-7(a)(8)(ii) and 2a-7(d).

128

See

rule 2a-7(c)(4)(ii)(D).

Both such matters were raised in 2007 by money market funds' investment in SIVs, which we discussed briefly above. SIVs issued commercial paper to finance a portfolio of longer term, higher yielding investments, including residential mortgages. Unlike other commercial paper programs, SIVs typically did not have access to liquidity facilities to protect commercial paper investors (including money market funds) against the risk of the issuer's inability to reissue (or “rollover”) commercial paper caused by either a credit event of the issuer or a disruption in the commercial paper

market.

129

When they could no longer rollover their debt beginning in 2007, those SIVs, unable to secure liquidity support from sponsoring banks, were forced to begin selling the vehicles' assets into depressed markets to pay maturing debt and to begin winding down their operations. SIV credit ratings deteriorated rapidly as they deleveraged, placing pressure on valuations of SIV securities held by money market funds. We understand that eventually most funds holding SIV securities not supported by a large bank entered into agreements with affiliates of the fund to support the fund's stable net asset value per share.

129

For a discussion of the evolution of the asset backed commercial paper market and SIV securities during this period,

see generally

Jim Croke,

New Developments in Asset-Backed Commercial Paper

(2008), at 2-4,

available at http://www.orrick.com/fileupload/1485.pdf

We request comment on whether, and if so how, we should amend rule 2a-7 to address risks presented by SIVs or similar ABSs. As discussed above, rule 2a-7 requires that money market funds only invest in securities that the board of directors or its delegate determines present minimal credit risks.

130

The Commission has stated that “[d]etermining that an ABS presents minimal credit risks requires an examination of the criteria used to select the underlying assets, the credit quality of the put providers, and the conditions of the contractual relationships among the parties to the arrangement. When an ABS consists of a large pool of financial assets, such as credit card receivables or mortgages, it may not be susceptible to conventional means of credit risk analysis because credit quality is based not on a single issuer but on an actuarial analysis of a pool of financial assets.”

131

We also said, however, that we were concerned that “fund credit analysts may be unable to perform the thorough legal, structural and credit analyses required to determine whether a particular ABS involves inappropriate risks for money market funds” and, as a result, required that any ABS in which a money market fund invested be rated by an NRSRO because of NRSROs' role in assuring that the underlying ABS assets are properly valued and provide adequate asset coverage for the cash flows required to fund ABSs.

132

130

Rule 2a-7(c)(3)(i).

131

1993 Proposing Release,

supra

note 81, at text accompanying nn.108-109.

132

Id.

at nn.110-112 and accompanying text.

As discussed above, beginning in 2007, SIV securities were rapidly downgraded by NRSROs revealing money market funds' varying minimal credit risk determinations with respect to these securities. In light of this experience, should we provide additional guidance to money market funds on the required minimal credit risk evaluation with respect to ABSs? We believe that part of this analysis, when evaluating any security, should include an evaluation of the issuer's ability to maintain its promised cash flows which, in the case of an asset backed security, would entail an analysis of the underlying assets, their behavior in various market conditions, and the terms of any liquidity or other support provided by the sponsor of the security.

133

Should we amend rule 2a-7 to remove the requirement that any ABS be rated by an NRSRO in order to be an eligible security for money market funds in light of the NRSROs' recent rapid downgrading of these securities? Under our proposed liquidity requirements (discussed below), the liquidity features of an ABS would have to be considered in determining whether the fund holds sufficiently liquid assets to meet shareholder redemptions.

134

133

The ICI Report recommended that we amend rule 2a-7 to require money market fund advisers to adopt a “new products committee.”

See

ICI Report,

supra

note 6, at 79-80. Although such committees may be useful, their usefulness would turn on what might be a “new product” as well as the judgment of its members, whose judgment is today required to be brought to bear on whether the security presents minimal credit risks.

134

See infra

Section II.C.

We request comment on whether rule 2a-7 should explicitly require fund boards of directors (or their delegates) to evaluate whether the security includes any committed line of credit or other liquidity support. Are there other factors that we should require money market fund boards to evaluate when determining whether SIV investments or other new financial products pose minimal credit risks? We note that some money market funds invested more significantly in SIV securities while other money market funds avoided such investments entirely. Are there facets of the credit analysis that led certain money market funds to avoid such investments that should be incorporated explicitly into rule 2a-7?

135

Should we limit money market funds to investing in ABSs that the manager concludes can be paid upon maturity with existing cash flow,

i.e.,

the payment upon maturity is not dependent on the ability of the special purpose entity to rollover debt? Alternatively, should the rule itself require ABSs to be subject to unconditional demand features to be eligible securities?

136

135

The staff's recent examinations of money market funds indicate that credit analysts for money market funds that invested in SIVs that subsequently defaulted appear to have had access to the same basic set of information on SIVs as did analysts at money market funds that did not and that the judgment of these credit analysts regarding minimal creditworthiness of the SIVs that subsequently defaulted appeared to have been different. The staff's exams also appear to indicate that credit analysts for money market funds that invested in SIVs that subsequently defaulted placed less emphasis on the length of time that payment experience was available on assets in the collateral pool and they were willing to accept sub-prime mortgage credits as a seasoned asset class. In addition, their decision, in part, may have been influenced by the greater amount of over-collateralization of the collateral pools and the high yields paid by notes supported by sub-prime credits.

136

Rule 2a-7(a)(26) defines an “unconditional demand feature” as a “demand feature” that by its terms would be readily exercisable in the event of a default in payment of principal or interest on the underlying security or securities.

B. Portfolio Maturity

Rule 2a-7 restricts the maximum remaining maturity of a security that a money market fund may acquire, and the weighted average maturity of the fund's portfolio, in order to limit the exposure of money market fund investors to certain risks, including interest rate risk. The Commission is proposing changes to the rule's maturity limits to further reduce such risks, as discussed below. First, we propose to reduce the maximum weighted average portfolio maturity permitted by the rule. Second, we propose a new maturity test that would limit the portion of a fund's portfolio that could be held in longer term variable- or floating-rate securities. Third, we propose to delete a provision in the rule that permits certain money market funds to acquire Government securities with extended maturities of up to 762 calendar days. We are also requesting comment on other ways of adjusting the rule's maturity provisions in order to accomplish our goal of decreasing the risks associated with a money market fund holding longer term investments.

1. Weighted Average Maturity

Rule 2a-7 requires a money market fund to maintain a dollar-weighted average portfolio maturity appropriate to its objective of maintaining a stable net asset value or price per share, but in no case greater than 90 days.

137

We adopted this provision because securities that have shorter periods remaining until maturity (and are of higher quality) generally exhibit a low level of volatility and thus provide a greater assurance that the money market fund will continue to be able to maintain a stable share price.

138

137

See

rule 2a-7(c)(2)(iii).

138

See

1983 Adopting Release,

supra

note 3, at n.7 and accompanying text.

Having a portfolio weighted towards securities with longer maturities poses several risks to a money market fund. First, as we have noted in the past, a longer weighted average maturity increases a fund's exposure to interest rate risk.

139

Second, and as we discuss in more detail below, longer maturities also amplify the effect of widening credit and interest rate spreads on a fund.

140

Finally, a fund holding securities with longer maturities generally is exposed to greater liquidity risk, because fewer securities mature on a daily or weekly basis. Perhaps in recognition of these risks, few fund managers maintain weighted average maturity at or near the maximum permissible 90 days.

141

139

See

1990 Proposing Release,

supra

note 22, at text accompanying n.60.

See also

Standard & Poor's, Money Market Fund Ratings Criteria, at 21 (2007)

available at http://www2.standardandpoors.com/spf/pdf/events/MMX709.pdf

(“S&P 2007 Ratings Criteria”) (“The portfolio's weighted average maturity (WAM) is a key determinant of the tolerance of a fund's investments to rising interest rates. In general, the longer the WAM, the more susceptible the fund is to rising interest rates. A fund comprised entirely of Treasury securities with a WAM of 45 days could withstand approximately twice the interest rate increase than could a fund with a 90-day WAM, leaving all other factors aside.”); Fabozzi,

supra

note 98, at 4 (“[T]he volatility of a bond's price is closely associated with maturity: Changes in the market level of [interest] rates will wrest much larger changes in price from bonds of long maturity than from otherwise similar debt of shorter life.”).

140

See also

ICI Report,

supra

note 6, at 184, Appendix H.

147

See

S&P 2007 Ratings Criteria,

supra

note 139, at 21; Moody's Investors Service, Frequently Asked Questions about Moody's Ratings of Managed Funds, at 4 (July 20, 2005),

available at http://www.moodys.com/moodys/cust/research/MDCdocs/20/2003600000425726.pdf?search=5&searchQuery=Frequently+Asked+Questions+about+Moody

; Fitch Ratings, U.S. Money Market Fund Ratings, at 4 (Mar. 3, 2006),

available at http://www.fitchresearch.com/creditdesk/reports/report_frame.cfm?rpt_id=266376

148

See

proposed rule 2a-7(c)(2)(ii).

We request comment on the proposed 60-day weighted average maturity limit. Would it decrease portfolio volatility and increase fund liquidity, as we suggest? What would be the anticipated effect on money market fund yields? Would a negative effect on yields make money market funds less attractive to investors? Should a different weighted average maturity limit apply, such as 45 days or 75 days? We request that commenters provide us with data demonstrating the effect that alternative weighted average maturity limits would have had on portfolios of money market funds during the recent economic turmoil.

2. Weighted Average Life

We propose to add to rule 2a-7 a new maturity test, which would limit the weighted average life maturity of portfolio securities to 120 days.

149

As explained further below, the weighted average life of a portfolio would be measured without regard to a security's interest rate reset dates, and thus would limit the extent to which a fund could invest in longer term securities that may expose a fund to interest rate spread risk and credit spread risk.

150

149

See

proposed rule 2a-7(c)(2)(iii).

150

While the proposed rule would ignore interest rate resets for purposes of calculating the fund's weighted average life to maturity, a security's demand features could continue to be used in this calculation.

See, e.g.,

rule 2a-7(d)(3) and (d)(5).

Generally, under rule 2a-7 the maturity of a portfolio security is the period remaining until the date on which the principal must unconditionally be repaid according to its terms (its final “legal” maturity) or, in the case of a security called for redemption, the date on which the redemption payment must be made.

151

The rule contains exceptions from this general approach for specific types of securities, which are referred to as the “maturity shortening” provisions.

152

Among these exceptions are three provisions that allow a fund to treat a variable- or floating-rate security as having a maturity equal to the time remaining to the next interest rate reset

date.

153

First, a fund may treat a short-term variable-rate security (

i.e.

, one with a remaining maturity of 397 days or less), as having a maturity equal to the earlier of the interest rate reset date or the time it would take the fund to recover the principal by exercising a demand feature.

154

Second, a fund may treat a short-term floating-rate security (

i.e.

, one with a remaining maturity of 397 days or less) as having a maturity of one day.

155

Third, a variable- or floating-rate Government security generally may be deemed to have a maturity equal to the next reset date even if it is a long-term security.

156

For purposes of calculating weighted average maturity, the rule effectively treats short-term variable- and floating-rate securities and all adjustable-rate Government securities as if they were a series of short-term obligations that are continually “rolled over” on the reset dates at the current short-term interest rates.

151

See

rule 2a-7(d).

152

Id.

We added maturity shortening provisions to the rule in 1986; they are particularly important for tax exempt funds, which invest in municipal obligations, most of which are issued with longer maturities.

See

1986 Adopting Release,

supra

note 19, at nn.9-10 and accompanying text.

153

See

rule 2a-7(a)(13) (defining “floating rate security”) and (a)(29) (defining “variable rate security”). The interest rate for a variable-rate security is established on set dates, whereas the interest rate for a floating-rate security adjusts whenever a specified interest rate changes. We also may refer to variable- and floating-rate securities collectively in this Release as “adjustable-rate” securities.

154

See

rule 2a-7(d)(2).

See also

rule 2a-7(a)(8) (definition of “demand feature”).

155

See

rule 2a-7(d)(4).

156

See

rule 2a-7(d)(1) (allowing a variable-rate Government security where the variable rate is readjusted no less frequently than every 762 days to be deemed to have a maturity equal to the period remaining until the next readjustment of the interest rate, and a floating-rate Government security to be deemed to have a remaining maturity of one day).

As the ICI Report explains, however, longer term adjustable-rate securities are more sensitive to credit spreads (the amount of additional yield demanded by purchasers above a risk-free rate of return to compensate for the credit risk of the issuer) than short-term securities with final maturities equal to the reset date of the longer term security.

157

Longer term adjustable-rate securities also are subject for a longer period of time to risk from widening interest rate spreads.

158

As a result, prices of longer term adjustable-rate securities could fall more than prices of comparable short-term securities in times of market turbulence. The ICI Report also notes that while adjustable-rate securities do protect a fund against changes in interest rates, permitting maturity shortening based on interest rate resets does not protect against liquidity risk to the portfolio.

159

157

See

ICI Report,

supra

note 6, at 77.

158

Interest rate spreads can widen because a variable-rate note has a fixed period of time to the next interest reset date and during that time the benchmark interest rate will likely change. Interest rate spreads can also widen because market conditions change after the security is issued such that investors may demand a greater margin to hold the security.

See

Fabozzi,

supra

note 98, at 196.

159

See

ICI Report

, supra

note 6, at text accompanying n.140.

We are concerned that the traditional weighted average maturity measurement of rule 2a-7 does not require that a manager of a money market fund limit these risks. We understand that some money market fund portfolio managers, to protect the fund, have already begun using a weighted average maturity measurement that ignores interest rate resets.

The ICI Report confirms our observations of the behavior of prices for certain securities last fall, when money market funds found it difficult to sell at amortized cost longer term adjustable-rate securities, including securities issued by agencies of the federal government. We believe that the use of the measurement the ICI recommends, which we will call the “weighted average life” to maturity of a money market fund portfolio, appears to be a prudent limitation on the structure of a money market fund portfolio and would limit credit and interest rate spread risks not encompassed by the weighted average maturity restriction of rule 2a-7. As suggested by the ICI Report, we are proposing that money market funds maintain a weighted average life of no more than 120 days.

160

The Commission believes that a 120-day weighted average life requirement would provide a reasonable balance between strengthening the resilience of money market funds to market stress (

e.g.

, interest rate increases, widening spreads, and large redemptions) while not unduly restricting the funds' ability to offer a diversified portfolio of short-term, high quality debt securities.

160

The proposed rule would require a money market fund to maintain a weighted average maturity not to exceed 120 days, determined without reference to the exceptions in paragraph (d) of the rule regarding interest rate resets.

See

proposed rule 2a-7(c)(2)(iii).

One of the effects of a limit on the weighted average life of a portfolio would appear to be on funds that hold longer term floating-rate Government securities, which are issued by federal agencies. Consider a money market fund with a portfolio consisting 50 percent of overnight repurchase agreements and 50 percent of two-year Government agency floating-rate obligations that reset daily based on the federal funds rate. Using the reset dates as permitted by the rule's maturity shortening provisions, the portfolio would have a weighted average maturity of one day. In contrast, by applying a measurement that does not recognize resets, the portfolio would have a weighted average life of 365.5 days (

i.e.

, half of the portfolio has a one day maturity and half has a two-year maturity), which would be considerably longer than the 120-day limit we are proposing. The weighted average life limitation would provide an extra layer of protection for funds and their shareholders against spread risk, particularly in volatile markets.

We request comment on all aspects of the proposed weighted average life limitation. Is this new maturity test appropriate? Is 120 days an appropriate limit? What would be the effect on yield? Does it place too much of a constraint on the ability of money market fund advisers to effectively manage fund portfolios? Does it permit funds to assume too much risk? Would a different limit be more appropriate, such as 90 days or 150 days? Would the proposed weighted average life limitation have a material impact on the issuers of short-term debt and, if so, what would it be?

We request comment on whether there are alternative approaches to measuring these risks. We understand that some fund managers use an alternative maturity test that focuses solely on credit spread risk. Such a test not only disregards interest rate resets, but also excludes Government securities from the weighted average maturity calculation. Would this test provide a clearer indication of the overall credit spread risk of the portfolio? Are there other advantages to such an approach? If so, what would be an appropriate limit? Should it be the same as proposed weighted average life limitation of 120 days, or should it be different, such as 90 days or 150 days? We request that commenters provide us with data demonstrating the effect of such alternative credit limitations and/or weighted average life limitations on their portfolios during the recent economic turmoil.

When the Commission first adopted rule 2a-7, we explained that we were allowing Government securities to use resets for purposes of the maturity limitations under the rule because we understood that the volatility of such instruments would be no greater than the volatility of fixed interest rate instruments having a maturity equal to the period before the security's interest rate reset.

161

The Commission noted, however, that this position was based entirely upon experience with Small Business Administration guaranteed debentures—at the time the only

adjustable-rate Government securities of which the Commission was aware.

162

The Commission stated that it would consider amending this provision if market experience indicates that such treatment is inappropriate.

163

161

See

1983 Adopting Release,

supra

note 3, at n.16.

162

See id.

163

See id.

Since 1983, the number and variety of adjustable-rate Government securities have grown and, in particular, the issuance of such securities by Freddie Mac and Fannie Mae increased significantly with the growth in mortgage-backed securities. While adjustable-rate securities historically have maintained market values similar to equivalent short-term fixed-rate securities, last fall these Government securities experienced increased credit and interest rate spreads and greater volatility than Government securities with maturities similar to the reset dates of the adjustable-rate securities.

164

Further, as noted above, other short-term adjustable-rate securities also experienced increased credit and interest rate spreads and greater volatility than securities with maturities similar to the reset dates.

164

See

Jody Shenn,

Fannie Mae Debt Spreads Hit Records as GMAC Seeks Bank Status

, Bloomberg, Nov. 20, 2008; Jody Shenn,

Agency Mortgage-Bond Spreads Head for Worst Month on Record

, Bloomberg, Oct. 31, 2008,

available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aSc8k8D7ZMw0

Currently, rule 2a-7 permits funds to rely on these reset provisions to shorten portfolio maturities only if boards or their delegates can reasonably expect that the security's market value will approximate its amortized cost on the reset date.

165

However, recent experience suggests that in times of market stress, this expected performance may not hold true. Would the weighted average life to maturity limitation adequately address this risk? Are there other alternative limitations or tests that would have mitigated this risk last fall? Should we restrict a fund's ability to use the maturity-shortening provisions of the rule to those adjustable-rate securities, including Government securities, with maximum final maturities of no more than two years, three years, or four years? What would be the impact of the weighted average life limitation on longer term adjustable-rate Government securities issuers?

165

See

rule 2a-7(a)(13) and (a)(29).

3. Maturity Limit for Government Securities

The Commission is proposing to delete a provision of the rule that permits a fund that relies exclusively on the penny-rounding method of pricing to acquire Government securities with remaining maturities of up to 762 days, rather than the 397-day limit otherwise provided by the rule.

166

We are unaware of money market funds today that rely solely on the penny-rounding method of pricing, and none that hold fixed-rate Government securities with remaining maturities of two years, which we are concerned would involve the assumption of a substantial amount of interest rate risk. We request comment on our proposal to delete the provision. Are we correct that funds no longer use it? If not, are there reasons why we should retain it?

166

See

rule 2a-7(c)(2)(ii). We added this provision in 1991.

See

1991 Adopting Release,

supra

note 20, at nn.53-57 and accompanying text. In a conforming change, we also propose to revise the maturity-shortening provision of the rule for variable-rate Government securities to require that the variable rate of interest is readjusted no less frequently than every 397 days, instead of 762 days as currently permitted.

See

rule 2a-7(d)(1); proposed rule 2a-7(d)(1).

4. Maturity Limit for Other Portfolio Securities

Currently, in order to qualify as an eligible security under rule 2a-7, an individual security generally cannot have a remaining maturity that exceeds 397 days.

167

We request comment on whether we should consider reducing the maximum maturity for individual non-Government securities acquired by a money market fund from 397 days to, for example, 270 days.

168

167

See

rule 2a-7(a)(10)(i) and (c)(2)(i).

168

A maturity limit of 270 days would be consistent with the exemption for commercial paper under section 3(a)(3) of the Securities Act of 1933 [15 U.S.C. 77c(a)(3)].

The length of time remaining before a security matures affects its sensitivity to increases in interest rates. In addition, a shorter maturity decreases the amount of time a fund is exposed to potential investment losses for a particular security. On the other hand, it is less clear that such a change would produce a significant increase in the safety and stability of money market funds if we were to adopt it in addition to adopting the proposed 60-day weighted average maturity and 120-day weighted average life limitations. Moreover, unlike the weighted average maturity and weighted average life limitations, a stricter maturity limitation on individual securities could have a substantially greater adverse impact on issuers of short-term obligations other than commercial paper, including issuers of tax exempt municipal securities.

What would be the effects on money market funds and the capital markets of shortening the maturity limit on individual portfolio securities to 270 days? Would there be benefits to funds from shortening the maturities of individual securities beyond the benefits that would be attained through the 60-day weighted average maturity and 120-day weighted average life limitations? What would be the likely impact on money market fund yields? What effect, if any, would shortening the maturity limit have on the supply of rule 2a-7-eligible securities? Should Government securities be excluded from a 270-day maturity limit?

169

If we were to adopt a maximum 270-day maturity for individual securities, should we include or exclude securities issued by municipalities, which typically issue debt securities with maturities of a year or more?

169

We note that, while posing less credit risk, Government securities are subject to much the same risks as corporate securities from rising spreads between their market price and money market benchmarks, whether due to liquidity concerns, changes in interest rates, or other factors. For this reason some rating agencies have imposed limitations on remaining maturities of adjustable-rate Government securities held by money market funds.

See, e.g.

, S&P 2007 Ratings Criteria,

supra

note 139, at 30 (setting a two-year limit for remaining maturities of floating- or variable-rate Government securities held by money market funds for the fund to maintain the highest rating).

C. Portfolio Liquidity

Rule 2a-7 does not contain any provisions limiting the ability of a money market fund to hold or acquire illiquid assets.

170

Money market funds are, however, subject to section 22(e) of the Act, which requires registered investment companies to satisfy redemption requests in no more than seven days—a requirement we have construed as restricting a money market fund from investing more than 10 percent of its assets in illiquid securities.

171

Since rule 2a-7 was first adopted we have emphasized the importance of a money market fund holding sufficiently liquid securities. Money market funds often have a greater, and perhaps less predictable, volume of redemptions than other open-end investment companies.

172

And because many promise to provide redemptions sooner than other types of open-end funds—often on the same day that the redemption request is received—money market funds need

sufficient liquidity to meet redemption requests on a more immediate basis.

173

170

See

1983 Adopting Release,

supra

note 3 at n.37 and accompanying text (“[Rule 2a-7] does not limit a money market fund's portfolio investments solely to negotiable and marketable instruments * * *.”).

171

See, e.g., id.

at nn.37-38 and accompanying text; 1986 Adopting Release,

supra

note 19, at n.21 and accompanying text.

172

See, e.g.

, 1986 Adopting Release,

supra

note 19, at text preceding and accompanying n.22; 1983 Adopting Release,

supra

note 3, at text following n.39.

173

See

1983 Adopting Release,

supra

note 3, at text following n.39.

By holding illiquid securities, a money market fund exposes itself to a risk that it may be unable to satisfy redemption requests promptly, without selling illiquid securities at a loss that could impair its ability to maintain a stable net asset value per share.

174

Illiquid securities also complicate the valuation of the fund's portfolio.

175

Moreover, illiquid securities are subject to greater price volatility, exposing the fund to greater risk of breaking a buck as a result of net asset values eroding in a declining market.

176

174

Id.

at text preceding, accompanying and following nn.37-39.

175

Id.

at text preceding section titled “Obligation of the Board to Maintain Stable Price.”

176

S&P 2007 Ratings Criteria,

supra

note 139, at 21.

We have not included a specific provision in rule 2a-7 regarding liquidity because, until recently, money market funds had not experienced a severe liquidity shortfall. As discussed above, in September 2008, the markets for both traditional and asset-backed commercial paper essentially seized up. Large portions of many money market fund portfolios became illiquid when buyers of asset-backed and traditional commercial paper fled the market.

177

At the same time, many money market funds—principally institutional money market funds—received substantial redemption requests.

178

The ability of these funds to maintain a stable net asset value turned on their ability to convert portfolio holdings to cash without selling them at “fire sale” prices.

177

See

Board of Governors of the Federal Reserve, Report Pursuant to Section 129 of the Emergency Economic Stabilization Act of 2008: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (undated),

available at http://www.federalreserve.gov/monetarypolicy/files/129amlf.pdf

at 1-2 (“In ordinary circumstances, MMMFs would have been able to meet these redemption demands by selling assets. At the time of the establishment of the AMLF, however, many money markets were extremely illiquid, and the forced liquidation of assets by MMMFs was placing increasing stress on already strained financial markets.”);

see generally

Board of Governors of the Federal Reserve, Monetary Policy Report to the Congress (Feb. 24, 2009), Part 2,

http://www.federalreserve.gov/monetarypolicy/mpr_20090224_part2.htm.

178

See

ICI Mutual Fund Historical Data,

supra

note 47 (in the week ending September 17, the day after the Reserve Primary Fund announced that it would break a dollar, institutional money market fund assets fell by more than $119 billion while retail money market fund assets fell by $1.1 billion).

These events suggest to us that rule 2a-7 should be amended to address liquidity risks that money market funds face. We propose to amend rule 2a-7 to add new risk-limiting conditions designed to improve money market funds' ability to meet significant redemption demands.

1. Limitation on Acquisition of Illiquid Securities

We propose to prohibit money market funds from acquiring securities unless, at the time acquired, they are liquid,

i.e.,

securities that can be sold or disposed of in the ordinary course of business within seven days at approximately their amortized cost value.

179

In light of the risk to the fund of securities becoming illiquid as a result of market events, such as those that occurred last fall, investing any portion of the fund in securities that are already illiquid may be imprudent and thus should be prohibited by rule 2a-7.

179

Proposed rule 2a-7(c)(5). “Liquid security” would be defined in proposed rule 2a-7(a)(19). Last year in the

NRSRO References Proposal, we proposed to define “liquid security” as a security that can be sold or disposed of in the ordinary course of business within seven days at approximately the cost ascribed to it by the money market fund.

See supra

note 105, at n.28 and accompanying text.

See also

1986 Adopting Release,

supra

note 19, at text following n.21 (“The term `illiquid security' generally includes any security which cannot be disposed of promptly and in the ordinary course of business without taking a reduced price.”). The one comment we received on the proposed definition recommended the definition refer to the “shadow price” rather than the “value” ascribed to the security by the money market fund. Most funds that rely on rule 2a-7 value their securities using the amortized cost method and thus would be required to acquire securities that can be sold or disposed of in the ordinary course of business within seven days at approximately amortized cost value.

We request comment on our proposal to preclude funds from acquiring illiquid securities. We understand that some funds make very limited investments in securities that, at the time of acquisition, are illiquid, such as insurance company funding agreements, loan participations, and structured notes that have no demand features. Would this proposed provision (which would not prohibit funds from continuing to hold securities that become illiquid after their purchase) have a significant impact on money market funds? What would be the impact on funds of not being able to buy illiquid securities? Would there be a material impact on yield?

2. Cash and Securities That Can Be Readily Converted to Cash

As discussed above, liquidity of a money market fund portfolio is critical to the fund's ability to maintain a stable net asset value. Our traditional notions of liquidity incorporated into our guidelines (discussed above) appear to be inadequate to meet the needs of a money market fund because the guidelines assume that a fund has time (up to seven days) to sell securities and that there will be a market for the securities. As noted above, money market funds typically undertake to pay their investors more quickly (frequently the same or following day). As the events of last fall demonstrated, money market funds may be unable to rely on a secondary or dealer market ready to provide immediate liquidity at amortized cost under all market conditions. Therefore we are proposing new liquidity tests that would be based on the fund's legal right to receive cash rather than its ability to find a buyer of the security.

The amount of liquidity a fund will need will vary from fund to fund and will turn on cash flows resulting from purchases and redemptions of shares. As a general matter, a fund that has some large shareholders, any one of which could redeem its entire position in a single day, will have greater liquidity needs than a retail fund that has thousands of relatively small shareholders. A fund that competes for yield-sensitive shareholders (

e.g.,

“hot money”) through electronic “portals” will have substantially greater liquidity needs than a fund holding the cash of commercial enterprises that have predictable needs (such as payrolls).

180

See Money Market Funds Tackle “Exuberant Irrationality,”

Standard & Poor's, RatingsDirect (Sept. 30, 2008),

available at http://www2.standardandpoors.com/spf/pdf/media/MoneyMarketFunds_Irrationality.pdf

(“It is likely that certain yield-sensitive institutions commonly referred to as ‘hot money' accounts, moved money from one investment to another to capture a higher yielding, or seemingly safer, option. For example, after Lehman Bros. filed for bankruptcy, corporations that issued commercial paper (CP) to fund their business operations were forced to pay a significantly higher premium to obtain funding because of investor concerns with holding debt from any nongovernment issuer. The subsequent `flight to quality' pushed some overnight and 30-day CP rates up by 0.5% (to approximately 3.5%) for issuers whose credit or financial/risk profile did not seem to change. As a result, these hot money accounts moved their investments from money market funds yielding less than 2.75%.”).

Our proposed formulation of a new liquidity standard is designed to take into consideration each of these factors. The proposed daily and weekly standards, discussed immediately below, would be minimum standards; the proposed general standard (which we discuss after the minimum standards) may require a fund to maintain a higher portion of its portfolios in cash or securities that can readily be converted into cash.

a. Minimum Daily Liquidity Requirement

Taxable Retail Funds.

We propose to require each taxable retail money market fund to invest at least five percent of its assets in cash, U.S. Treasury securities, or securities that can provide the fund with daily liquidity,

i.e.,

securities that the fund can reasonably expect to convert to cash within a day.

181

Unlike our liquidity guidelines discussed above, which allow for a period during which a fund would be expected to seek buyers in a secondary market, these daily liquidity requirements would be significantly more demanding, requiring a portion of the funds' assets be held in “daily liquid assets,” which the rule would define as: (i) Cash (including demand deposits); (ii) securities (including repurchase agreements) for which the fund has a contractual right to receive cash within one business day either because the security will mature or the fund can exercise a demand feature;

182

or (iii) U.S. Treasury securities, which have historically traded in deep, liquid markets, even in times of market distress.

183

181

Proposed rule 2a-7(c)(5)(iii).

182

A “demand feature” means a feature permitting (i) the holder of a security to sell the security at an exercise price equal to the approximate amortized cost of the security plus accrued interest, if any, at the time of exercise, and (ii) the holder of an asset backed security unconditionally to receive principal and interest within 397 calendar days of making demand. Rule 2a-7(a)(8).

183

U.S. Treasury securities were highly liquid last fall.

See, e.g., FRB Open Market Committee Oct. 28-29 Minutes, supra

note 51, at 5 (“Yields on short-term nominal Treasury coupon securities declined over the intermeeting period, reportedly as a result of substantial flight-to-quality flows and heightened demand for liquidity. In contrast, higher term premiums and expectations of increases in the supply of Treasury securities associated with the Emergency Economic Stabilization Act and other initiatives seemed to put upward pressure on longer term nominal Treasury yields. Yields on longer term inflation-indexed Treasury securities, which are relatively illiquid, rose more sharply than did those on nominal securities.”);

Minutes of the Federal Open Market Committee,

Federal Reserve Board, Dec. 15-16, 2008, at 5,

available at http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20081029.pdf

(“

FRB Open Market Committee Oct. 28-29 Minutes”)

(Dec. 15-16, 2008), at 4,

available at http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20081216.pdf

(“Yields on nominal Treasury coupon securities declined significantly over the intermeeting period in response to safe-haven demands as well as the downward revisions in the economic outlook and the expected policy path. Meanwhile, yields on inflation-indexed Treasury securities declined by smaller amounts, leaving inflation compensation lower. Although the decline in inflation compensation occurred amid sharp decreases in inflation measures and energy prices, it was likely amplified by increased investor preference for the greater liquidity of nominal Treasury securities relative to that of inflation-protected Treasury securities.”).

Under the proposed amendments, a money market fund that is a “retail fund” could not acquire any securities other than daily liquid assets if, immediately after the acquisition, the fund would have invested less than five percent of its total assets in those assets (“minimum daily liquidity requirement”).

184

Compliance with the daily liquidity requirement would be determined at the time each security is acquired, and thus a fund would not have to dispose of less liquid securities (and potentially realize an immediate loss) if the portion of the fund held in highly liquid securities fell below five percent as a result of redemptions.

184

The term “daily liquid assets” is defined in proposed rule 2a-7(a)(8). A “retail fund” would be defined as any fund other than an institutional fund. Proposed rule 2a-7(a)(24). For a discussion of the definition of “institutional fund,”

see infra

text preceding, accompanying and following note 196. “Total assets” means with respect to a money market fund using the amortized cost method, the total amortized cost of its assets and, with respect to any other money market fund, the total market-based value of its assets. Rule 2a-7(a)(27).

Retail money market funds experienced relatively modest redemption demands last fall, even in the midst of substantial market turbulence.

185

Thus we believe that a five percent requirement, which was recommended in the ICI Report, may be sufficient.

186

We request comment on our analysis, and whether a five percent standard is appropriate in light of the liquidity needs of retail money market funds (which we distinguish from institutional money market funds in the next section of this release). Should we consider a higher percentage, such as 10 percent or 15 percent, or a lower percentage, such as two percent or three percent? Do our proposed amendments strike the right balance between reducing liquidity risk and limiting the impact on yield? What would be the effect on yields of a lower or higher minimum daily liquidity requirement? There may be a number of factors that influence the lower redemption rates among retail investors, including investment purposes and practices, size of investments and possible differences in the information that retail as opposed to institutional investors obtain and the time when they obtain the information. We solicit comment on whether these factors did or would in the future influence the level of retail redemptions. If so, how should the proposed rule be revised to address such factors?

185

See supra

note 178. On September 17, 2008, approximately 4% of prime retail money market funds and 25% of prime institutional money market funds had outflows greater than 5%; on September 18, 2008, approximately 5% of prime retail funds and 30% of prime institutional funds had outflows greater than 5%; and on September 19, 2008, approximately 5% of prime retail funds and 22% of prime institutional funds had outflows greater than 5%. This information is based on analysis of data from the iMoneyNet Money Fund Analyzer database.

186

See

ICI Report,

supra

note 6, at 74.

We also request comment on the definition of “daily liquid assets.” Are there other securities that are sufficiently liquid that should be included in the definition?

A fund's contractual rights to cash will be different if the fund is relying on an unconditional demand feature rather than a conditional demand feature, which the fund may not be able to exercise if there is a default or other credit event with respect to the issuer of the securities.

187

Rule 2a-7 permits both to be used to shorten the maturity of an instrument.

188

For purposes of determining the daily liquidity requirement, should the rule distinguish between securities subject to conditional and unconditional demand features?

187

See

rule 2a-7(a)(26) (defining “unconditional demand feature”); rule 2a-7(a)(6) (defining “conditional demand feature”).

188

See

rule 2a-7(d)(3), (5).

As discussed above, compliance with the daily liquidity requirement would be determined at the time each security is acquired. A fund could acquire only daily liquid assets until the portfolio investments met the five percent daily liquidity test.

189

Because the requirement applies only at the time of acquisition, a money market fund would not have to maintain a specified percentage of its assets in daily liquid assets at all times (subject to the general liquidity requirement discussed below), even though the fund is exposed to liquidity risk at all times. We request comment on whether to impose a minimum liquidity maintenance requirement,

i.e.,

require that a money market fund maintain five percent of its portfolio at all times in daily liquid assets. What are the advantages and disadvantages of each approach?

189

This is also the approach rule 2a-7 takes with respect to money market fund credit quality and diversification requirements.

See

rule 2a-7(c)(3), (4).

Taxable Institutional Funds.

We propose to limit a taxable institutional fund to acquiring daily liquid assets unless, immediately after acquiring a security, the fund holds at least 10 percent of its total assets in daily liquid assets.

190

Institutional money market funds typically maintain a greater portion of their assets in cash and overnight repurchase agreements than retail funds, which reflects the greater

liquidity needs of these funds.

191

These greater needs were demonstrated last fall, when (as discussed above) institutional funds were subject to substantially greater redemption pressure than retail funds.

192

We understand that some of these institutional funds had cash positions of almost 50 percent in their portfolios in anticipation of substantial redemptions following the large amount of inflows during 2007 through August 2008.

190

Proposed rule 2a-7(c)(5)(iii).

191

This information is based on analysis of data from the iMoneyNet Money Fund Analyzer database.

192

See supra

note 178.

We request comment on whether institutional money market funds should be subject to a higher daily liquidity requirement (10 percent) than retail funds (five percent). Should we consider a higher percentage, such as 15 or 20 percent? Ten percent daily liquidity could seem high for a money market fund that reserved the right to delay payment of redemptions for seven days. We are not proposing to adjust the appropriate minimum daily liquidity requirement for institutional or retail funds solely by reference to the seven day period, however, because many money market funds undertake to pay redemption proceeds on the same day or the next day, and an announcement by a fund of a delay in payment of redemption could itself precipitate a run on funds. We request comment on whether a five percent daily liquidity requirement for retail funds or a 10 percent daily liquidity requirement for institutional funds should turn on the representations the money market fund has made to its investors regarding the timing of payments of redemption proceeds.

We propose to add two new definitions to rule 2a-7 to distinguish between retail and institutional money market funds. Although the ICI and others who compile data about money market funds have traditionally distinguished between retail and institutional money market funds, in practice the distinctions are not always clear.

193

An institutional fund may have investors who invest on behalf of retail investors. For example, institutional money market funds commonly have investors that are bank sweep accounts or master funds in master-feeder arrangements.

194

Although these investors ordinarily provide cash flows to the fund that are more similar to retail funds, a single decision-maker may be in a position to redeem all of the shares of the money market fund and move the sweep account to another money market fund. In addition, some funds have a single portfolio but issue separate classes of shares to retail and institutional investors that bear different expenses. In these cases, the cost of managing the institutional share class's relatively greater cash flow volatility is shared with the retail investors.

193

See, e.g.,

ICI, Frequently Asked Questions About Money Market Funds,

http://www.ici.org/faqs/faqs_money_funds

(describing (i) institutional money market funds as “held primarily by businesses, governments, institutional investors, and high-net worth households” that as of July 2008, held 63 percent of all money market fund assets and (ii) retail money market funds as “offered primarily to individuals with moderate-sized accounts” that as of July 2008, held around 37 percent of all money market fund assets); iMoneyNet home page,

http://imoneynet.com

/(separates information and analysis on money market funds into institutional and retail categories); Crane Data, Money Fund Intelligence (June 2009) at 30,

http://www.cranedata.us/products/money-fund-intelligence/

(select issue 2009-06-01 (Vol.4, #6)) (classifying money market funds as institutional or individual based on expense ratio, minimum investment and “who they're sold to”).

194

A “master-feeder fund” is an arrangement in which one or more funds with identical investment objectives (“feeder funds”) invest all their assets in a single fund (“master fund”) with the same investment objective. Investors purchase securities in the feeder fund, which is an open-end fund and a conduit to the master fund.

See

H.R. Rep. No. 622, 104th Cong., 2d Sess., at 41 (1996) (“H.R. Rep. No. 622”);

see generally

Exemption for Open-End Management Investment Companies Issuing Multiple Classes of Shares; Disclosure by Multiple Class and Master Feeder Funds; Voting on Distribution Plans; Final Rules and Proposed Rule, Investment Company Act Release No. 20915 (Feb. 23, 1995) [60 FR 11876, 11876-77 (Mar. 2, 1995)].

Our proposed amendments would require that a money market fund's board determine, no less frequently than once each calendar year, whether the fund is an institutional money market fund for purposes of meeting the liquidity requirements.

195

In particular, the fund's board of directors would determine whether the money market fund is intended to be offered to institutional investors or has the characteristics of a fund that is intended to be offered to institutional investors, based on the: (i) Nature of the record owners of fund shares; (ii) minimum amount required to be invested to establish an account; and (iii) historical cash flows, resulting or expected cash flows that would result, from purchases and redemptions.

196

The provision is designed to permit fund directors to evaluate the overall characteristics of the fund based on relevant factors.

197

Under the provision, a fund offered through two classes, a majority of whose shares are held by retail investors, should nonetheless be deemed to be an institutional fund by the fund board if the cash flows from purchases and redemptions and the portfolio management required to meet liquidity needs based on those cash flows are more characteristic of an institutional money market fund.

195

Proposed rule 2a-7(c)(5)(v).

196

Proposed rule 2a-7(a)(18) (defining “institutional fund”).

197

Proposed rule 2a-7(a)(24) would define “retail fund” as any money market fund that the board of directors has not determined within the calendar year is an institutional fund.

We request comment on our proposed definitions. The differences today in the liquidity management of institutional and retail money market funds suggest to us that fund managers (and perhaps fund boards) currently distinguish between retail and institutional funds. Would our proposed definition permit them to continue to draw the distinctions they draw today? Are there additional factors the board should consider in determining whether a fund is an institutional fund? Would a different approach result in better distinctions? If we cannot distinguish between retail and institutional funds, should we amend rule 2a-7 to apply the minimum daily liquidity requirements we propose for institutional funds to all funds? Would setting the same minimum daily liquidity requirement for institutional and retail funds impose unnecessary costs (in terms of lower yields) on retail investors in light of retail funds' reduced liquidity needs?

Might one effect of the proposed amendments be that funds currently offering two classes of shares, one retail and one institutional, would decide to divide the fund into two funds and manage them differently? Would one of the advantages of such a result be that retail investors would not bear the cost of maintaining liquidity for institutional investors? Would a disadvantage be the loss to retail investors of the economies of scale in these multi-class funds? What additional advantages and disadvantages do commenters foresee? Retail investors may not be aware of the higher redemption rates that institutional funds experienced last fall. Should we consider requiring institutional funds to provide additional disclosures regarding the risk to the fund of large redemptions?

Tax Exempt Money Market Funds.

We propose to exempt tax exempt funds from the minimum daily liquidity requirements.

198

We understand that most of the portfolios of tax exempt funds consist of longer term floating- and variable-rate securities with seven day demand features from which the fund obtains much of its liquidity. We understand that these funds are unlikely

to have investment alternatives that would permit them to meet a daily liquidity requirement.

199

We request comment on whether tax exempt money market funds could meet a daily liquidity requirement, such as we have proposed for taxable retail funds. Do tax exempt retail money market funds nevertheless have similar liquidity requirements as taxable retail funds? If so, should rule 2a-7 treat them differently and how?

198

Proposed rule 2a-7(c)(5). Rule 2a-7 defines a “tax exempt fund” as a money market fund that holds itself out as distributing income exempt from regular federal income tax. Rule 2a-7(a)(24).

199

See

ICI Report,

supra

note 6, at 74.

b. Minimum Weekly Liquidity Requirement

We propose that all money market funds (including tax exempt funds) also be subject to a minimum weekly liquidity requirement (“minimum weekly liquidity requirement”). Specifically, retail and institutional funds could not acquire any securities other than U.S. Treasury securities or securities (including repurchase agreements) that mature or are subject to a demand feature exercisable and payable in five business days (together with cash, “weekly liquid assets”) if, immediately after the acquisition, (i) the retail fund would have invested less than 15 percent of its total assets in weekly liquid assets and (ii) the institutional fund would have invested less than 30 percent of its total assets in weekly liquid assets.

200

Proposed rule 2a-7(c)(5)(iv). The term “weekly liquid assets” would be defined in proposed rule 2a-7(a)(32).

The proposed minimum weekly liquidity requirement would supplement the proposed minimum daily liquidity requirement (discussed above) and give greater assurance that money market funds could meet their statutory obligations to redeem shareholders in times of market turbulence. We estimate that under our proposed minimum weekly liquidity requirement, approximately 93 percent of retail funds and 91 percent of institutional funds would have been able to satisfy the level of redemption demands during the periods of greatest redemption pressure last fall without having to sell portfolio securities.

201

During the week of September 15-19, 2008, approximately 6% of retail funds had net redemptions that exceeded 15%, and 9% of institutional money market funds had redemptions that exceeded 30% of assets. In addition, in the 52 weeks preceding September 17, 2008, roughly the same portion of redemption requests in institutional and retail funds (less than 2%) would have exceeded the weekly liquidity requirements. This information is based on analysis of data from iMoneyNet Money Fund Analyzer database.

We request comment on the minimum weekly liquidity requirements. Would a minimum daily liquidity requirement alone be sufficient to allow funds to adequately manage risk in the event of unexpected shareholder redemptions in excess of the daily threshold and market illiquidity? Are the proposed minimums of 15 percent of a retail fund's total assets and 30 percent of an institutional fund's total assets sufficient?

202

Should we, as the ICI Report suggests, adopt the same (20 percent of total assets) test for both retail and institutional funds? As discussed above, we designed our minimum weekly liquidity requirements so that more than 90 percent of retail and institutional funds could have met redemption requests during the week of September 15-19, 2008 without selling portfolio securities. Should we set the threshold lower, such as at 80 percent or 70 percent? Should we set the threshold higher at 95 percent or 100 percent? The weekly liquidity requirement would be essentially the same as the daily liquidity requirement, except that the fund must be able to access cash on a weekly rather than daily basis. Compliance with the test would be determined upon the acquisition of a security, and demand features could be used to determine the maturity of a portfolio security for purposes of the test.

202

We note that for most weeks during the past year, prime institutional money market funds maintained over 30% of their assets in securities maturing in seven days or less. This information is based on analysis of data from iMoneyNet Money Fund Analyzer database.

We propose to treat as weekly liquid assets for purposes of the weekly liquidity requirements, the same securities that would be daily liquid assets except that the requirement for maturing securities or demand features would be five business days rather than one.

203

The ICI Report suggests that we ought to treat as a weekly liquid asset a security issued by an agency of the U.S. Government that, when originally issued, had a maturity of 95 days or less.

204

Is there a basis on which to treat these agency securities as weekly liquid assets? If so, why should the maturity of the security be 95 days based on original issue rather than specifying a period remaining to maturity? We urge commenters supporting such treatment to submit market data to support their views.

203

Compare

proposed rule 2a-7(a)(8) with proposed rule 2a-7(a)(32).

204

See

ICI Report,

supra

note 6, at 74.

c. General Liquidity Requirement

As discussed above, the daily and weekly liquidity requirements would be minimum requirements a fund would have to satisfy upon acquisition of a security. A fund's liquidity needs, however, depending upon the volatility of its cash flows, may be greater. Therefore, we also propose to require that a money market fund at all times hold highly liquid securities sufficient to meet reasonably foreseeable redemptions in light of its obligations under section 22(e) of the Act and any commitments the fund has made to shareholders, such as undertaking to pay redemptions more quickly than seven days.

205

Proposed rule 2a-7(c)(5)(ii). Our proposal is similar to the liquidity standard we proposed last year in the proposal on NRSRO references.

See

NRSRO References Proposal,

supra

note 105, at Section III.A.2. Among the commenters that specifically addressed that proposed standard, two suggested that codification of the standard was not needed because money market fund advisers already understand and adhere to the current standards.

See

Comment Letter of Fidelity Management & Research Company (Aug. 29, 2008) (File No. S7-19-2008); Comment Letter of the Securities Industry and Financial Markets Association Credit Rating Agency Task Force (Sept. 4, 2008) (File No. S7-19-2008). A third suggested eliminating the standard because it involves “subjective, forward-looking estimates,” while retaining a proposed maximum level for illiquid securities holdings to “preserve a clearer bright-line test”).

See

Comment Letter of Morrison & Foerster (Sept. 5, 2008) (File No. S7-19-2008).

To comply with this condition, we would expect money market funds to consider a number of factors that could affect the fund's liquidity needs. For example, a money market fund would have to understand the characteristics of its investors and their likely liquidity needs. A volatile investor base,

e.g.,

one consisting of a few relatively larger investors that are likely to make significant redemptions, would require a fund to maintain greater liquidity than a stable investor base, which is generally associated with a retail fund with many hundreds or thousands of smaller investors. With this information, a fund manager could take different steps to protect the fund from greater liquidity risk. For example, the fund manager could increase

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